If you are a fixed-income investor, your enthusiasm for Treasury bonds may be tepid because of their paltry yields. Another drawback: Treasury bond returns don’t keep up with inflation as it goes higher.

As the economy picks up momentum, it’s likely that inflation could start to rise. That’s why you might consider investing in Treasury inflation-protected securities, or TIPS, to provide balance as part of a diversified portfolio.

What are TIPS?

TIPS help protect you against inflation by rising in value in tandem with the consumer price index, or CPI. But the coupon rate doesn’t change over time.

How do TIPS work?

When Consumer Price Index is …

TIPS’ principal value goes …

Interest payout goes …

Up

Up

Up slightly

Down

Down

Down slightly

Instead, the government adjusts the principal amount of your TIPS every 6 months based on actual inflation changes in the CPI. If inflation goes up, your principal amount will be upwardly adjusted, too. And since your interest payment is based on this increased principal amount, your interest payment adjusts upward, too.

But the inverse can occur, too. If inflation goes down, your principal is adjusted downward, and so is your twice-a-year interest payout.

Hypothetical 5-year TIPS with a coupon rate of 0.125%

Year

Principal

value

Change

in CPI

(in %)

Adjusted

principal

value

Interest

payment

1

$1,000

+ 2

$1,020

$1.28

2

$1,020

+ 3

$1,050.60

$1.31

3

$1,050.60

– 1

$1,040.10

$1.30

4

$1,040.10

+ 1

$1,050.50

$1.31

5

$1,050.50

+ 2

$1,071.51

$1.34

At the bond’s maturity, the principal payment that you get back will be the greater of the inflation-adjusted amount or at least your initial principal.

Break-even rate

Regular U.S. Treasury bonds do have an inflation premium built into their yield to compensate for expected inflation, but it’s not foolproof. If your Treasury bond yield is 3% but inflation is running at 2% or higher, your real yield will end up being 1% or less.

Translation: Initially the yields on TIPS will be lower than those of traditional U.S. Treasury bonds because with TIPS, investors get some certainty about getting a real return, over and above inflation.

On the other hand, if inflation turns out to be below this break-even rate, or yield differential, the TIPS investor will be worse off, getting a lower return than the investor in a Treasury bond. But if inflation actually ends up running higher than expected, the TIPS investor will wind up getting a better return than the Treasury bond investor.

Planning for inflation

TIPS make sense for retirees on a fixed income, who could lose purchasing power if they invest in securities that don’t keep up with inflation.

“For retirement planning, or other types of liability-based investment planning, if you were looking to lock in a real yield over a specific period of time, TIPS are the one way you can do that,” says Franco Castagliuolo, a fixed-income portfolio manager for Fidelity Investments. “You can do that with this sector far better than you could with just about any other sector of fixed income.”

However, the level of inflation protection you get may not necessarily reflect your situation perfectly. That’s because the CPI tracks price changes to a certain basket of consumer goods — the CPI for All Urban Consumers, or CPI-U — that broadly reflects economy-wide inflation.

Meanwhile, your personal expenditures aren’t likely to break down in the same way. For instance, if a large portion of your expenses are for health care, the changes in the CPI may not accurately reflect your costs.

Similarly, the CPI’s weighting for education expenses may not accurately reflect an investor’s personal situation.

TIPS subject to oil volatility

Considering that oil prices are a key input for the CPI, TIPS are also subject to the influence of volatile oil prices. On the way down, oil prices serve as a headwind for TIPS, and as they rise, they serve as a tailwind.

“The effects of oil and gas tend to be greater on shorter-maturity TIPS than on longer-maturity TIPS,” says James Ong, a senior macro strategist for Invesco Fixed Income in Atlanta. “That’s because in the longer term you would expect all these fluctuations in energy to eventually average themselves out, while in the short term these changes might have a bigger impact.”

Another risk: Even though TIPS have been around since 1997, they are relatively new compared with regular Treasuries and are not as liquid. This means that if you want to sell your TIPS bond in the secondary market, you might not get your expected price.

Beware interest rate risk

And while investors in TIPS don’t have to deal with credit risk, or the risk of default by the U.S. government, investors are still subject to interest rate risk or changes in the market prices of TIPS as interest rates change. This also applies to funds investing in TIPS.

Tannuzzo expects that if the Federal Reserve starts to raise interest rates later this year, TIPS prices will move a bit lower. However, he expects TIPS to take less of a price hit than Treasury bonds. “We think the break-even rate, the cost of inflation protection, is pretty low and pretty reasonable,” he says. “It is a hurdle, but it is likely to be cleared. So it is likely that TIPS do better than nominal Treasuries.”

Another factor going for TIPS, according to Tannuzzo, is that aggressive bond purchases by central banks in Japan and Europe will likely reignite inflation globally. This inflation pressure will rub off on the U.S. over time, even as the Fed starts taking interest rates higher.

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